Page 95 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2. Average Cost/Composite/Overall Cost: It is the average of various specific costs of the
different components of equity, preference shares, debentures, retained earnings of capital
structure at a given time and this is used as the acceptance criteria for (capital budgeting)
investment proposals.
3. Historic Cost/Book Cost: The book cost has its origin in the accounting system in which
book values, as maintained by the books of accounts, are readily available. They are
related to the past. It is in common use for computation of cost of capital. For example, cost
of capital may be computed based on the book value of the components of capital structure.

Did u know? Historical costs act as guide for future cost estimation.
4. Future Cost: It is the cost of capital that is expected to raise funds to finance a capital budget
or investment proposal.
5. Specific Cost: It is the cost associated with particular component/source of capital. It is
also known as component cost of capital. For example, cost of equity (Ke) or cost of
preference share (Kp), or cost of debt (Kd), etc.
6. Spot Cost: The costs that are prevailing in the market at a certain time. For example, few
years back cost of bank loans (house loans) was around 12 per cent, now it is 6 per cent is
the spot cost.
7. Opportunity Cost: The opportunity cost is the benefit that the shareholder foregoes by
not putting his/her funds elsewhere because they have been retained by the management.
For example, an investor, had invested in a company's equity shares (100 shares, each
share at 10). The company decided to declare dividend of 10 per cent on book value of
share, but due to capital requirements it retains its investment on one project that is
having return on investment (RoI) of 4 per cent. Elsewhere, the project rate of interest
(banks) is at 6 per cent. Here, the opportunity cost to the investor is (6-4) 2 per cent.

8. Explicit Cost: Cost of capital can be either explicit or implicit. Distinction between explicit
and implicit is important from the point of view of computation cost of capital. An explicit
cost of any source of capital is the discount rate that equates the present value of the cash
inflows, that are incremental to the taking of the financing opportunity with present value
of its increments cash outflows. In other words, the discount rate that equates the present
value of cash inflows with present value of cash outflows. It is also called as the internal
rate of return. For example, a firm raises 1,00,000 through the sale of 12 per cent perpetual
debentures. There will be a cash inflow of 1,00,000 and a cash outflow of 12,000 every
year for a indefinite period. The rate that equates the PV of cash inflows ( 1,00,000) and PV
of cash outflows ( 12,000 per year) would be the explicit cost. Computation of explicit cost
is almost similar to the computation of IRR, with one difference.

9. Implicit Cost: It is the cost of opportunity, which is given up in order to pursue a particular
action. It is also known as implicit cost of capital. The implicit cost of capital of funds
raised and invested by the firm may, therefore be defined as "the rate of return associated
with the best investment opportunity for the firm and its shareholders that would be
foregone, if the projects presently under consideration by the firm were accepted. The cost
of retained earnings is an opportunity cost of implicit cost for a shareholder, who is
deprived of the opportunity to invest retained earnings elsewhere. Funds raised by any
form of financing have implicit capital costs once they are invested. Thus, in a sense,
implicit costs may also be viewed as opportunity costs. This implies that a project reflects
negative PV, when its cash flows are discounted by the implicit cost of capital.

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